Everybody knows the deal these days on natural gas. E&P companies like Cabot Oil & Gas (NYSE:COG) have been incredibly successful at finding and exploiting new sources of natural gas, but the U.S. energy infrastructure has not shifted as radically. Consequently, inventories are high and prices are low, which has kept a lid on many of the stocks. Although Cabot's near-term valuation wouldn't suggest that it's a compelling buy, I think a longer-term perspective suggests a different answer.
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Growth Is Definitely Not the Problem
Cabot is by no means struggling to post impressive-looking production growth numbers. For the second quarter, for instance, the company saw 40% year-on-year production growth - and that was actually disappointing due to infrastructure delays in the key Marcellus region.
Production growth is only part of the story, though. Realized prices were down 48% from last year, and that's an incredibly difficult headwind to offset. Likewise, unit production costs continue to rise (about 13% year on year), and that sent unit profits spiraling down (down 74% from last year's second quarter).
A Top-Notch Player
It's not always easy to see the quality of a commodity producer when the commodity in question is under serious pressure. Now, natural gas has rebounded strongly since the spring, buoyed in part by demand from electrical utilities, but still stands below $3 per million BTUs. At this level, it's hard for even the best companies to make real profits.
Nevertheless, Cabot has the markings of an excellent company. The company's finding and development (F&D) costs are among the lowest in the industry, as are its lifting costs. What's more, when you compare its capital productivity to other well-run names like Ultra Petroleum (NYSE:UPL), Southwestern (NYSE:SWN) and Range Resources (NYSE:RRC), Cabot looks quite good indeed, with nearly twice the productivity.
Gas Today and Gas Tomorrow
While Cabot has been exploring liquids-rich asset plays in the Anadarko (where initial Marmaton results have looked quite good) and the Eagle Ford, let's not get carried away. With over 96% of Cabot's 2011 year-end proven reserves in natural gas, this is going to be a natural gas story.
Therefore, it probably goes without saying that the future of natural gas pricing is of central importance to Cabot. Sooner or later, I think prices have to increase. With current prices making it so difficult to make money, many producers have switched over to produce as much oil as possible. At the same time, there are compelling long-term arguments for more gas-fired electricity generation in the U.S.
It's also worth considering the international arbitrage angle. Right now, liquified natural gas imports are going for about $14.50/MMBtu in Japan. That discrepancy creates a lot of incentive to build LNG terminal facilities, and that's actually happening in the U.S. right now - though not at the pace natural gas bulls may like.
The Bottom Line
Cabot's huge position in the Pennsylvania Marcellus, as well as other assets like Utica, Eagle Ford, Anadarko and so on, suggests a lot of potential production growth over the coming years. At the same time, the company's conservative management and cost discipline points to the probability of that being profitable production growth.
Unfortunately, today's numbers don't work out so well. Analysts are still conservative on natural gas prices in 2013 and 2014 and that is compressing EBITDA estimates - making Cabot's valuation appear not-so-compelling. And to be fair, if natural gas prices do stay below $4 or $3.50, it's hard to argue for owning this stock. Taking a longer-term view, though, and assuming that U.S. natural gas prices will close the gap with international prices, Cabot looks like a high-quality way to play a better future for natural gas.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.